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2 What is Human Capital?Part of original conception of inputs in production. Adam Smith said that there were 4 inputs in which we might invest:Machines or mechanical inputsBuilding/infrastructurelandhuman capital

3 Education and “General” Human CapitalWe’re going to study first education (schooling including college/graduate education)This is important because it is:Expandable and maybe doesn’t depreciate (like physical capital)Transportable and shareable (not true with “specific capital”)

4 What are we going to study?TheoryStatic Model (Card)Dynamic Model (Heckman)The goal of theory is to motivate the large body of empirical workEmpiricsSome talk of methods (identification, diff-in-diff, IV)Reconciling different estimatesEconomics of Education (briefly!)

8 Some Empirical Facts1. A simple regression model with a linear schooling term and a low-order polynomial in potential experience explains 20-35% of the variation in observed earnings data, with predictable and precisely-estimated coefficients in almost all applications.2. Returns to education vary across the population with observables, such as school quality or parent’s education

9 OLS Estimates1. 10 percent upward bias on OLS estimates of the return to education (based on the most recent, “best” twins studies)2. Estimates of the return to schooling based on brothers or fraternal twins contain positive ability bias, but less than the corresponding OLS estimate.

10 Does IV Fix the problem?IV estimates of the return to education based on family backgroundsystematically higher than corresponding OLS estimatesprobably have a bigger ability bias than OLS estimatesIV estimates of the return to education based on intervention in the school systemabout 20 percent more than the OLS estimates.return to schooling for these subgroups are especially high, and cannot be generalized to the population.

11 A Static Model of Education and EarningsBecause of its tractability, Card uses a static model that abstracts away from the relationship between completed schooling and earnings over the lifecycle. (we’ll do a dynamic model next).Two assumptions:that most people finish schooling and only then enter the labor force (smooth transition).the effect of schooling independent of experience (Separability above)

12 The basics Simple Linear regression first introduced by MincerTakes the general form of linearity in Schooling, quadratic in experience.Assumptions:separability of experience and education.log-earnings are linear in education.correct measure of schooling is years of educationeach year of schooling is the same. (more on this later)

13 Wages or earnings? Earnings conflates hours and wagesCard reports that about two-thirds of the returns to education are due to the effect of education on earnings—the rest attibutable to the effects on hours/week and week/year.The specification in (1) explains about percent of the variation in earnings data.

14 Why use Semi-Log Specification?log earnings are approximately normally distributed.Heckman and Polachek show that the semi-log form is the best in the the Box-Cox class of transformations. (we can talk about this more later in the empirical part)

16 Simple relationship between returns and costsSo that we have h(S) = r*Smore generally we could have a convex h(.) function if the marginal cost of each year of schooling increases faster than the foregone earnings for that year—maybe because of credit constraints)

17 Results Optimal schooling is implicitly defined byThat is there are two sources of heterogeneity:Differences in costs (represented by h(S))Difference in marginal returns (represented by y’(S)/y(S))

18 Optimal Schooling a simple specification of these two components(define E(b) = b and E(r)= r and k1, k2> 0)This gives us the optimal schooling expression:

19 Interpretation of EquilibriumIndividuals do not necessarily know the parameters of their earnings functions when they make their schooling choices.bi interpretation: individual's best estimate of his/her earnings gain per year of education, as of early adulthood.One might expect this estimate to vary less across individuals than their realized values of schoolingthe distribution of bi may change over time with shifts in labor market conditions, technology, etc. (Skill Premium)

20 Some Assumptionstreat bi as known at the beginning of the lifecycle and fixed over time:assumption probably leads to some overstatement of the role of heterogeneity of bi in the determination of schooling and earnings outcomes.for simplicity, assume jointly symmetric distribution of b and r.

21 Returns to schoolingFrom our equilibrium expression (4) can get expression for returns to schoolingEven in this simple model there is a distribution of returns unlessLinear indifferent curves with uniform slopeLinear opportunity curves, with uniform slope

22 Within vs. Between VariationWithin: Eq. (4) as a partial equilibrium description of the relative education choices of a cohort of young adults, given their family backgrounds and the institutional environment and economic conditions that prevailed during their late teens and early 20s.Differences across cohorts in these background factors will lead to further variation in the distribution of marginal returns to education in the population as a whole.

23 Earnings and Schooling EqnFrom equation 3A (FOC), we getNote that individual heterogeneity affects both the intercept and the slopeDefining αi = ai + a0Use this with eqn (4), to define schooling choice in terms of a, b, and r(5)

24 Linear Estimating FunctionDefine λ0 and ψ0 as the parameters from the linear projection of ai and bi on where is E(Si )(6a)(6b)That is:

25 OLS estimates of bUsing this notation, we can write the probability limit of the OLS estimate:(7)where the avg. marginal return to schooling in the population is:

26 Homogeneous Returns Let bi = b and k1 = 0Then (5) implies the OLS estimate is not consistent, with upward bias of l0 %.The bias comes from the correlation of ability to the marginal cost of schooling.

27 Heterogeneous SchoolingReintroducing a heterogeneous bwe get additional bias terms in due to the self-selection of years of schooling.The size of this bias depends on the importance of the variation in b in determining the overall variance of schooling outcomes.

28 What did we learnThe linear model appears to fit so well because there is a bias introduced by heterogeneity which is convex and independent of the concavity of the opportunity curve.More simply put, the concavity from quadratic term in (5) is offset by the convexity from y0 giving an approximately linear relationship.

30 Understanding Observed Linearity-2Case 2:ai and bi both vary across individuals.cross-sectional upward bias because of self selection.So depending on the relative variance of these components will determine the convexity and concavity.

31 Understanding Observed Linearity-3Rewrite (5) and reorganize terms:This is linear if ψ0≈ 2k1The bigger the contribution of bi to the overall variance of schooling, ψ0 is bigger and the more the convexity

32 What about Measurement Error?The downward bias of measurement error is often thought to offset some if not all of the upward bias in a,b from ability,only be true if the error is not correlated with level of schoolingUnlikely because individuals with high levels of schooling cannot report positive errors in schooling whereas individuals with very low levels of schooling cannot report negative errors in schooling.Given this correlation, the measurement error may actually exacerbates the attenuation bias.

33 IV in a Heterogeneous Worldeven minor difference in mean earnings between the two groups will be exaggerated by the IV procedure.For example, natural experiments inference are based on small differences between groups of individuals who attended schools at different times, places, etc. However, the uses of these differences might be difficult to generalize.

34 IV-2Define a linear relationship between returns to schooling and a set of characteristics, Z, i.e.So the earnings function can be rewritten as:

35 IV-3The big news: In the presence of heterogeneous returns to education the conditions to get an interpretable IV estimator of very strong.The requirements are that we have individual specific heterogeneity components that are mean independent of the instrument.The second moment of the return to education is also independent of the instrumentThe conditional expectation of the unobserved component of optimal school choice is linear in b.

36 Family Background IV-1The strategy: use variables such as parents education, characteristics of parents to control for unobserved ability.The key idea: if a and S uncorrelated then we get an unbiased estimate, otherwise, we get an upward bias

38 Comparing Regressions: Homogeneous CaseIn order to compare this to the regression of a on S alone, define:Using these, we could compare three potential estimators:OLS from univariate regression of earnings on schooling—bOLSOLS from bivariate regression of earnings on schooling and family background—bbivIV estimator using Fi as an instrument for Si (bIV)

40 Siblings/Twins ModelsThe key idea behind this strategy: some of the unobserved differences that bias a cross-sectional comparison of education and earnings are based on family characteristicsKey Assumption: within families, these differences should be fixed.Differencing between schooling levels of individuals will yield consistent results.

41 Defining “Family Effect”Define “pure family effects” model as the aij=aj and bij=bjlinear projection of a and bi – b on the observed schooling outcomes of the two family members:

42 Estimating with “Family Effects”Assuming that bi, S1i, S2i have a jointly symmetric distributionEarning functions are then:Taking differences, a within family difference in log earnings model:

43 When Family Effects Models WorkWith identical twins, it is natural to impose the symmetry conditions so that λ1=λ2=λ, ψ1=ψ2=ψ andWith these assumptions and the pure family effects specification, all biases from ability and schooling are sucked up by the family average schooling component which differences out.

44 When Family Effects Don’t WorkIn the case of siblings, or father-son pairs it seems less plausible.Relax the family effects model as follows:

45 Why doesn’t it workFor a randomly-ordered siblings or fraternal twins, it is natural to assume that the projection coefficients satisfy the symmetry restrictions so that λ11=λ22, λ12=λ21, ψ12=ψ21, ψ11=ψ21From this, the earnings model eqn’s are:From this system, is not identifiable.

46 “Family Effect” or OLS Models?Without a “pure family effect” and symmetric it is only possible to estimate an upper bound measure of the marginal returns to schooling.there is no guarantee that this bound is tighter than the bound implied by the cross-sectional OLS estimator.It is possible that the OLS estimator has a smaller upward bias than the within family estimator.

47 Take-Homes from the Static Model 1The OLS estimator has two ability biases,the interceptthe slope.The bias in the slope may be relatively small if there is not much heterogeneity.The necessary conditions for IV estimators to be consistent is strictmany plausible instruments recover only the weighted average of marginal returns of the affected subgroups.. If the OLS estimator is upward biased, then the IV estimator is likely even more so

48 Take-Homes from the Static Model 2If twins or siblings have identical abilities, then a within-family estimator will recover an asymptotically unbiased estimatorotherwise a within-family estimator will be biasedthe extent to which depends on the relative importance the variance in schooling attributable to ability differences in families versus the population.

49 Take-Homes from the Static Model 3Measurement errors biases are potentially important in interpreting the estimates from different procedures.OLS estimates are probably downward biased by about 10%OLS estimates that control for family background may be downward biased by about 15% or morewithin-family differenced estimates may be downward-biased by 20-30% with the upper range more likely for identical twins.

50 Empirical Estimates Author Instrument OLS IV Angrist and KruegerQuarter of birth.070(.000)0.101(0.033)Staiger and Stock(Quarter of birth)*(state)*(year).063.060(.030)Kane and RouseTuition at 2 and 4 year state colleges and distance to nearest college.080(.005).091(.033)CardDistance to nearby 4-year collegeDistance*parent education--.097(.048)Conneely and UusitaloIndicator for living in university town in 1980.085(.001).110(.024)MalluccioDistance to local private school or high school.073/.063(.011)/(.006).145/.113(.041)/(.033)Harmon and WalkerChanges in minimum schooling leaving age.061.153(.015)

51 Does this Explain Differences in Empirical Estimates? -1Appears that IV-based studies estimate a return to schooling that’s about 30% more than OLS estimates: Why?Bound and Jaeger:IV estimate are even further upward biased than the corresponding OLS estimates by unobserved differences between the characteristics of treatment and comparison groups implicit in the IV scheme..

52 Does this Explain Differences in Empirical Estimates? -2Ability bias is that OLS estimates of the return to schooling are relatively smallthe gaps between IV and OLS estimates reflect the downward bias in OLS estimates attributable to measurement error.Most likely: measurement error bias itself seems like it could only explain about 10% of the bias.

53 Does this Explain Differences in Empirical Estimates? -3Publication bias: only want to publish papers with large and significant point estimatesAshenfelter and Harmon cite a positive correlation across studies between IV-OLS gap in estimated returns and the sampling error of the IV estimates.

54 Does this Explain Differences in Empirical Estimates? -4Underlying heterogeneity:Factors like compulsory schooling or accessibility of schools are more likely to affect the schooling choices of individuals who would otherwise have relatively low schooling levels.If these individuals have higher than average marginal returns to schooling, then IV estimators based on compulsory schooling or school proximity should yield higher than average marginal returns.

55 General ConclusionsConsistent with summary of the literature from the 60s and 70s by Grilliches,the average return to education in a given population is not much below the estimate that emerges from a simple cross-sectional regression of earnings on education.The “best available” evidence from the latest studies of identical twins suggests a small upward bias of about 10% in the simple OLS estimatesEstimate of the return to schooling based on comparisons of brother or fraternal twins contain some positive ability biasless than the corresponding OLSability differences appear to exert relatively less influence on within-family schooling difference

56 General Conclusions 2IV estimates of the return to education based on family background are systematically higher than corresponding OLS estimates and may contain a bigger upward biasReturns to education vary across the population with such observable factors as school quality and parental educationIV estimates of the return to education based on interventions in the school system tend to be 20% or more above the corresponding OLS estimates. There is some evidence that this is due to the higher than average marginal returns of the individuals targeted by these programs.